Look to India, not Russia, for a small-cap resurgence

IvanMartchev

Ivan Martchev is an investment specialist with institutional money manager
Navellier and Associates.
Previously, Ivan served as editorial director at
InvestorPlace Media. Ivan was
editor of Louis Rukeyser's Mutual Funds and associate editor of Personal
Finance. Ivan is also co-author of
The
Silk Road to Riches (Financial Times Press).

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The dismal multi-year relative performance of emerging-market small caps seems to be coming to an end, at least in some major markets. India is one place where this is happening. Russia, for obvious reasons, is left out of this recovery.

Mark Twain famously noted that "all generalizations are false, including this one." By his yard stick, the MSCI Emerging Market Index — the benchmark for emerging-markets investors — is a bit of a false generalization. This is because there are many countries with diverse cultures and various levels of development represented in this index, whose local economies and stock markets perform differently. You can say that the MSCI EM Index is as important for emerging-market investors as the S&P 500 is important for investors interested in the U.S. stock market. Yet, as an index, it is quite a bit different compared with the S&P 500.

First, the number of index components is not fixed. On May 30, the index had 823 components, but that number changes slightly from quarter to quarter. The MSCI EM index covers equities with a total market cap of $3.9 trillion, yet it is not necessarily a large-cap index. Yes, the Gazproms and Samsungs of the emerging world are all there, but there are a 50 to 100 large- or mega-cap companies, while the rest are small and mid caps. The current average market cap is only $4.76 billion while the median is $2.31 billion. Sure the mega caps pull it in their direction — the top 10 components have a combined market cap of $652.9 billion — but there are many interesting things going on under the surface that one might miss by just looking at the main index, investable via the iShares Emerging markets ETFEEM, -0.22%

Since 2011, when the MSCI EM Index began underperforming the S&P 500, small caps within the index did quite a bit worse than what one would observe when looking only at the flagship EEM ETF. This can be seen in the bigger BRIC markets that are represented in the MSCI EM Index that also have small-cap ETFs — the Market Vectors India Small-Cap ETFSCIF, +0.68%
the Market Vectors Brazil Small Cap ETFBRF, +0.80%
and the Market Vectors Russia Small Cap ETFRSXJ, -0.52%
and the iShares MSCI China Small-Cap ETFECNS, -0.54%
illustrate this point.

China

Chinese small caps have been recovering for a while, but China has an opaque stock market where profit growth is not the main driver due to the interventionist nature of the Chinese government. Chinese equities in general can diverge significantly from what one would expect from the level of economic growth. This is why China remains a stock-picker's market where fast economic growth offers opportunities to invest in single companies, yet investing in broad indexes and ETFs is more challenging.

The rest of the BRIC quartet, though, until recently, have had weak small-cap sectors amidst rangebound large-cap sectors. Brazil, Russia and India have delivered somewhat disappointing economic growth, which has compressed valuations in their respective stock markets. That has now started to change as stock markets often turn before the economies they are supposed to reflect. In India, economic issues contributed to a landslide election victory for the pro-business BJP party, which lit a fire under the stock market and allowed it to break out of its range to a fresh all-time high.

India

While some investors might be skittish to chase stock markets at all-time highs, keep in mind that emerging markets' underperformance has been going on since 2011, and the recent sights of outperformance may lead to a much longer period where economic growth and profit growth give a longer-lasting boost to share prices. I believe there is value in Indian small caps, which are moving even faster than the Indian large-cap Sensex benchmark, but in contrast to the Sensex, the Indian small-cap benchmarks are far from all-time highs, which can be best seen in the Market Vectors Small Cap India ETF.

The BJP won the strongest electoral mandate in 30 years on a pledge to build 100 new cities, run high-speed trains, and cut red tape to boost growth. Since the BJP has some track record of reform in its previous ruling mandate, the stock market has good reasons to rally. Still, the SCIF ETF hit a high of $95.48 in late 2011 and a low of $22.15 in 2013. Some of that decline has to do with a weakening rupee, but most of the damage was due to exceptionally weak small-cap sector that saw valuation compression form a PE of close to 20 down into the single digits over the same time frame. Yes, SCIF has more than doubled off the lows, but it is far from an all-time high both in price and valuation.

Russia

One place where this nascent resurrection of small-cap sectors in emerging markets is completely missing is in Russia. This former BRIC powerhouse is not doing well due to its geopolitical situation and involvement in Ukraine. While the West spins Mr. Putin as evil, many fail to mention his 80% approval rating at home.

In my opinion, one reason is the line of thinking that Ukraine's former president was toppled with substantial foreign interference, and that the Yanukovytch ouster is a covert attack on Russian national interests. Ukraine is the ultimate Gazprom choke hold, and whoever controls it, controls the pipelines that carry 55% of Gazprom's European exports. This is why I have great suspicion that the present Russian envoy in Kiev is doing anything more than buying time for the rebels to regroup.

Russia is the cheapest emerging market, and for the time being, it will likely remain cheap and underperform as the Ukrainian situation develops.

Ivan Martchev is an investment specialist with institutional money manager Navellier and Associates. The opinions expressed are his own. Navellier and Associates holds a position inGazpromfor some of its clients. This is neither a recommendation to buy nor sell the securities mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.

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